REMIC sponsor may recognize losses despite secured-financing accounting

Plain-English summary

A life insurance subsidiary transferred mortgage-backed securities to a trust that elected REMIC status. It received regular interests represented by notes, sold those notes to investors, and retained the residual interest. The parent guaranteed payments, the subsidiary retained a last-bid right in a future auction, and the companies treated the arrangement as secured financing for statutory accounting. Those features led the IRS examination team to question whether the trust had received the benefits and burdens of ownership and whether a REMIC had been formed for federal tax purposes. The national office concluded that the REMIC statute and regulations supplied the controlling rules and that every statutory and regulatory requirement was met. The subsidiary could recognize a capital loss on the sold regular interests and an ordinary loss on the retained residual interest ratably over the REMIC's anticipated life.

Ruling snapshot

• Question: Could the subsidiary claim a capital loss on sold REMIC regular interests and an ordinary loss on its retained residual interest?
• Outcome: Approved.
• Key authorities: IRC §§ 165, 860D, and 860F(b)(1); Treas. Reg. §§ 1.860F-2(b)(2) and 1.860F-2(b)(4).

Full text (IRS public release)

                    INTERNAL REVENUE SERVICE
          NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                 November 21, 2014

                                          Third Party Communication: None
                                          Date of Communication: Not Applicable

Number: 201517007
Release Date: 4/24/2015
Index (UIL) No.: 860F.04-00
CASE-MIS No.: TAM-108896-14

Industry Director, Financial Services
Large Business & International

  Taxpayer's Name:                        ---------------------------------
  Taxpayer's Address:                     --------------------------------
                                          -----------------------------
  Taxpayer's Identification No            -----------------
  Year(s) Involved:                       -------
  Date of Conference:                     No Conference Held

LEGEND:

Taxpayer = ---------------------------------
Subsidiary = --------
Bank A = -----------------------------------------
State A = --------------
Statutory Trust Year 3 = ------------------------------
Rating Agency = -------------------------
Clearing Agency = -------
RMB Securities = --------------------------------------------------------
a = -----
b = --------------
c = --------------
d = --------------
e = --------------
f = ----------------
g = ----------------
h = ----

TAM-108896-14 2

i = ------------
j = --------
k = --
l = --------------
m = ------
n = ----
o = ----------------
p = -------
q = --------------
r = ----
s = ----
t = ----------------
u = -----------------------
v = --------------
w = ---------------------
x = -----------------------------
y = -----------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
Month 1 = ---------
Month 2 = -------
Month 3 = ----------------
Month 4 = -----------
Date 1 = ----------------------
Date 2 = ----------------------------
Date 3 = -----------------------------
M = ----
N = ---------
P = ----
Q = ----

ISSUE(S):

1. Whether Subsidiary may take a capital loss from the sale or exchange of REMIC
   regular interests?

2. Whether Subsidiary may take an ordinary loss on a retained REMIC residual
   interest under § 860F(b)(1)(D)(ii) of the Internal Revenue Code and § 1.860F-
   2(b)(4)(iv) of the Treasury Regulations?

TAM-108896-14 3

CONCLUSION(S):

1. Subsidiary may take a capital loss from the sale or exchange of REMIC regular
   interests.

2. Subsidiary may take an ordinary loss on a REMIC residual interest under
   § 860F(b)(1)(D)(ii) and § 1.860F-2(b)(4)(iv).

FACTS:

Taxpayer is the parent (“Parent”) of a life-nonlife consolidated group (hereinafter, “the
group”). Subsidiary is a subsidiary of Taxpayer and is a life insurance company both for
statutory accounting purposes and as defined under § 816.

Background

At the time of the transaction described below, Subsidiary owned a portfolio of a
residential mortgage backed securities (RMB Securities), consisting of regular interests
in real estate mortgage investment conduits (REMICs). The RMB Securities were
purchased by Taxpayer between Year 1 and Year 2. The RMB Securities were backed
primarily by “subprime” mortgages. By Year 3, many of the RMB Securities were
reported by Subsidiary as “other than temporarily impaired” for statutory accounting
purposes and as partially worthless under § 166. At the time of the transaction, the
RMB Securities had a face value of approximately $b, an adjusted tax basis of $c, a
statutory accounting statement value of approximately $d, and a “fair value” of
approximately $e. According to one of Taxpayer’s internal projections, the cash flows to
be received from the RMB Securities were approximately $f between Month 2 Year 3
and Month 3 Year 4, $g between Month 4 Year 4 and Month 3 Year 5, and the balance,
or $g, in the following h years. All of the RMB Securities were held outside of the closed
block of assets dedicated to Taxpayer’s demutualized policyholders.

The Transaction

In Month 1 Year 3, Subsidiary formed a statutory trust, Statutory Trust Year 3 (Trust),
under the laws of State A. The Trust elected to be treated as a REMIC with the
calendar year as its taxable year. Under the terms of the Trust Agreement, Subsidiary,
as Depositor, sold all of its right, title, and interest in the RMB Securities in exchange for
REMIC regular and residual interests. Subsidiary retained the right to pursue certain
claims with respect to the RMB Securities. Assignment of the RMB Securities was
intended to be a sale of the RMB Securities by the Subsidiary to the Trust. The Trust
also received a perfected first priority secured interest in the RMB Securities. To perfect
the assignment of the RMB Securities to the Trust and the subsequent grant of security
to the Indenture Trustee for the benefit of the Noteholders, Subsidiary caused the RMB
Securities to be registered in the name of, or endorsed to, the Indenture Trustee, an

TAM-108896-14 4

independent third party. Pursuant to the Indenture, the RMB Securities were deposited
in a securities account in the name of the Indenture Trustee with the Clearing Agency.
No legal opinion was obtained regarding whether the transfer of the RMB Securities to
the Trust constituted a true sale in part because of the Parent Guaranty, discussed
below.

The Trust issued two classes of securities: the Notes and a Certificate. The Notes
represent REMIC regular interests and state that the Noteholders have the benefit of
the Parent Guaranty and the Make-Whole Guaranty. The Notes are secured by the
RMB Securities. The Notes were initially issued to Subsidiary, which immediately sold
them to capital market investors (Noteholders) for their market and face value of $i. The
Certificate represents a REMIC residual interest. The Certificate was retained by
Subsidiary and is subject to transfer restrictions to prevent transfers to disqualified
persons. Subsidiary, as holder of the Certificate, is the beneficiary of the Trust, but
Subsidiary’s rights to the Trust estate are subject to the Trust’s obligations to the
Noteholders under the Indenture and to the security interest over the Trust assets
granted to the Indenture Trustee for the benefit of the Noteholders.

Each Note bears an issue date of Date 1, provides for semi-annual payments beginning
Date 2, and has a maturity date of Date 3. On each semi-annual payment date prior to
the maturity date of the Notes, interest on the Notes is payable at j percent, as well as a
principal payment in the amount of k percent of the initial principal balance of the Notes
(i.e., $l).

Payments of principal and interest from the RMB Securities are based on the cash flows
of the underlying securitized mortgages. On each semi-annual payment date prior to
the maturity date of the Notes, distributions from the Trust to pay the Noteholders are
made in accordance with the cash flow waterfall specified in the Indenture. Payments
of principal and interest to the Noteholders are not, however, directly linked to the
payments of principal and interest from the RMB Securities. The cash flow from the
RMB Securities for each semi-annual period prior to the maturity date of the Notes was
projected to exceed significantly the amount of principal and interest payable on the
Notes and the Parent Guaranty Fees for such period, and this has in fact been the case.
The Certificate holder is entitled to receive any cash collected on the RMB Securities
remaining for distribution after principal and interest on the Notes and the Parent
Guaranty Fee (discussed below) are paid, up to a limit of m percent of the initial amount
of the Notes. In Month 3 Year 4, a balloon payment of n percent of the initial principal
balance, or $o, is due to the Noteholders, together with interest then due and payable.
After repayment of the Notes, the Certificate holder is entitled to any remaining net
assets in the Trust.

Taxpayer provided two forms of guaranties to the Noteholders. Pursuant to the “Parent
Guaranty,” Taxpayer unconditionally guarantees the prompt and complete payment of
principal and interest on the Notes when due. In return for the Parent Guaranty,

TAM-108896-14 5

Taxpayer receives a fee (Parent Guaranty Fee) at the rate of p percent per year of the
principal balance of the Notes prior to each payment date.

Taxpayer also provided a “Make-Whole Guaranty,” designed to protect the Noteholders
against a reduction in the cash flow of the Trust available to make payments on the
Notes due to extraordinary prepayments on the RMB Securities. In that event,
Taxpayer agreed to pay a “make-whole premium” designed to compensate Noteholders
for interest that would be foregone as a result of any such prepayment of principal on
the Notes.

On an ongoing basis, the underlying RMB Securities had to generate approximately $q
(which amount decreased slightly for each subsequent semi-annual period as principal
on the Notes was amortized) in cash flow semi-annually to cover interest, principal and
Parent Guaranty Fees. The cash flow from the RMB Securities for each semi-annual
period was projected to exceed this amount significantly, but was not projected to cover
the entire cost of the balloon payment of principal on the Notes due in Month 3 Year 4.

Under the terms of the Indenture, on the maturity date of the Notes or the payment date
following an acceleration event, an auction will be held for the sale of the RMB
Securities pursuant to a plan of liquidation of the Trust. Bids for the RMB Securities will
be solicited from a list of nationally recognized broker dealers. Subsidiary, the Initial
Purchasers and their affiliates are allowed to bid in the auction. Prior to accepting the
highest auction price, the auction advisor must first notify Subsidiary of the highest
auction price and Subsidiary will be given two days to respond with a counteroffer. The
auction advisor may accept a third-party bid only if no higher counteroffer is received
from Subsidiary or its affiliates. If the auction bids received are insufficient to cover the
remaining principal balance and any unpaid interest on the Notes, any unpaid make-
whole premium, and unpaid trust expenses, the Trustee will not settle with any bidder
until Taxpayer pays the amount of any deficiency under the Parent Guaranty.

The Noteholders were advised that the secondary mortgage market was experiencing
disruptions that might continue to adversely affect the value of the RMB Securities. The
Noteholders were also advised that Subsidiary was conducting an investigation into the
accuracy of the offering materials provided to the original investors in the RMB
Securities and that Subsidiary was considering bringing misrepresentation and related
claims based on alleged inaccuracies in such materials to compensate it for losses
suffered from investing in the RMB Securities in reliance on such misrepresentations.
Because these losses had already been suffered by Subsidiary as of the time
ownership of the RMB Securities was transferred to the Trust (and because the related
claims were not assets that are permitted be held by a REMIC), the rights to any
recoveries in such actions were not transferred to the Trust and remained with
Subsidiary. The Indenture included an acknowledgement from investors that certain
personnel of the Initial Purchasers not involved with the offering of the Notes may have
material non-public information about the RMB Securities that will not be disclosed to

TAM-108896-14 6

investors. Subsidiary understands that such personnel of an Initial Purchaser may have
obtained non-public information if, e.g., such Initial Purchaser itself owned interests in
the RMB Securities of the same class as the RMB Securities or participated in the
original offering of those RMB Securities.

A condition of the issuance of the Notes was that they receive an M rating from Rating
Agency. The rating of the Notes was based on the rating of Taxpayer in light of its full
and unconditional guaranty with respect to payment of interest and principal on the
Notes and any make-whole premium. Under the Indenture, if the Indenture Trustee is
requested to take any action or give any consent, approval or waiver (including an
amendment or default related to any of the RMB Securities), it must act as directed by
Taxpayer, as guarantor under the Parent Guaranty or, if Taxpayer’s rating from Rating
Agency has declined below N as directed by Taxpayer and a specified percentage of
the Noteholders. Investors were advised that the Rating Agency did not assess the
RMB Securities or the structure of the Notes in determining the rating of the Notes, and
that the rating did not derive or relate in any way to the quality of the RMB Securities or
the mortgage loans securitized by the RMB Securities. At the time of the transaction,
approximately r percent of the RMB Securities had a P rating or lower, and s percent
were rated Q or lower. However, the fair value of the RMB Securities was
approximately $e, or approximately $t greater than the original principal amount of the
Notes, which provided a substantial amount of cushion to the Noteholders.

Pricing of the Notes was based on the price of U.S. Treasuries with comparable
maturities plus u. At the time of issuance of the Notes, a standard v senior unsecured
corporate bond issue of Taxpayer would typically be priced at w Treasuries plus x, or
about y less than the Notes.

Accounting Treatment

Statement of Statutory Accounting Principles (SSAP) 91R dictates that a transfer of
financial assets will be accounted for as a sale if three criteria are met. The first criteria
is that the transferred assets have been “isolated from the transferor,” that is, put
presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or
receivership. A trust arrangement such as the arrangement at issue in this case would
satisfy sale criteria if other facts and circumstances demonstrated that the transferred
financial assets had been put beyond the reach of the transferor and its creditors.

Accountants for Subsidiary concluded that sale accounting was not appropriate for
SSAP 91R purposes due to the failure to satisfy the first criteria. They noted that
counsel was unable to provide a legal “true sale” opinion “as proof that the risk and
rewards of ownership have transferred,” and that the inability to obtain a legal true sale
opinion was a strong indicator the assets were not isolated in the event of receivership.
Because all three criteria must be met to account for the transaction as a sale, Taxpayer
did not further evaluate the accounting for the transaction for SSAP 91R purposes. In

TAM-108896-14 7

its accounting treatment, Taxpayer and Subsidiary accounted for the transaction as a
secured financing.

Taxpayer’s Tax Treatment

Beginning in Year 3, the Trust elected to be a REMIC that has issued one class of
regular interests (represented by the Notes) and one class of residual interest
(represented by the Certificate).

Subsidiary intends to claim a capital loss in Year 3 under § 165 on the sale of the Notes
to the third party investors, measured by the difference between the “issue price” of the
Notes and their allocated tax basis. Subsidiary also intends to amortize an ordinary loss
over the expected life of the REMIC, based on the difference between the “issue price”
of the Certificate and Subsidiary’s allocated tax basis in the Certificate pursuant to
§ 860F(b)(1)(D)(ii).

Section 860F(b)(1)(B) provides that the adjusted bases of the regular and residual
REMIC interests received in exchange for a transfer of property shall be equal to the
aggregate adjusted bases of the property transferred. The adjusted basis shall be
allocated among the regular and residual interests received in proportion to the
respective fair market values of the interests.

Section 1.860G-1(d)(1) provides that if the interest is in a class that is retained by the
sponsor, the issue price is its fair market value on the pricing date (as defined in
§ 1.860F-2(b)(3)(iii)), if any, or, if none, the startup day, regardless of whether the
property exchanged therefor is publicly traded.

Subsidiary’s basis allocation and estimated tax losses -----------------are summarized
below.

              Aggregate           FMV           Allocated         Issue      Amount          Tax
              Tax Basis                         Tax Basis          Price     Realized        Loss

Notes --------------------------------------------------------------------------------------------------

Certificate --------------------------------------------------------------------------------------------------

Taxpayer took the position that Subsidiary’s sale of the REMIC regular interests
resulted in a capital loss under § 165 equal to the difference between the Subsidiary’s
allocated tax basis in the REMIC regular interests and their issue price. Taxpayer also

TAM-108896-14 8

took the position that Subsidiary would apply the rules of § 860F(b)(1)(D)(ii) and
§ 1.860F-2(b)(4)(iv) and deduct the excess of its basis in the REMIC residual interest
over the issue price of the REMIC residual interest over the anticipated weighted
average life of the REMIC, v years.

Service Position

The Service questioned whether Subsidiary’s transaction resulted in the formation of a
REMIC for federal tax purposes. Specifically, the Service asked whether, considering
the facts and circumstances (i.e., the Parent and Make-Whole Guaranties, the
Subsidiary’s right of last bid under the auction procedures, the Subsidiary’s retention of
the Certificate, and the Subsidiary’s nontax treatment of the transaction as a secured
financing), the Subsidiary did not transfer the benefits and burdens of ownership of the
securities to the Trust and the RMB Securities should not be treated as transferred to
the Trust for tax purposes.

If the Subsidiary did not transfer the RMB Securities to the Trust in exchange for REMIC
regular and residual interests, then the Service suggested that the transaction should be
recast as a secured loan in the form of the Notes issued by Taxpayer and Subsidiary
that are collateralized by the RMB Securities. If so, Taxpayer would not be entitled to
recognize a capital loss on the sale of the Notes under § 165, and also would not be
entitled to an ordinary loss on a retained REMIC residual interest under
§ 860F(b)(1)(D)(ii) and § 1.860F-2(b)(4)(iv) because a REMIC was not validly formed.

LAW AND ANALYSIS

We have been asked to determine whether Subsidiary is allowed a capital loss from the
sale or exchange of the REMIC regular interests and whether Subsidiary is allowed a
loss on the REMIC residual interest under § 860F(b)(1)(D)(ii) and § 1.860F-2(b)(4)(iv).
Taxpayer states that it complied with the REMIC statute and regulations and it is
therefore entitled to a capital loss upon the sale of the REMIC regular interest as well as
a loss on the retained residual interest.

The REMIC statute and regulations clearly evidence a Congressional intent that these
rules be the exclusive means for determining REMIC characterization. The REMIC
statute and regulations provide rules regarding the treatment of mortgage
securitizations if certain requirements have been met. The legislative history of §§ 860A
through 860G of the Code further emphasizes that the tax consequences of REMIC
transactions are governed exclusively by the REMIC rules.

The Senate Report on the Tax Reform Act of 1986, which added §§ 860A through 860G
to the Code, states that Congress enacted the REMIC rules to clarify the considerable
uncertainty concerning the federal income tax treatment of real estate mortgages traded
on secondary markets and multiple class arrangements used in the “packaging” of such

TAM-108896-14 9

mortgages. See S. Rep. No. 99-313, 99th Cong., 2d Sess., at 791 et. seq. The Senate
Report states that Congress believed the best method to clarify this uncertainty was “to
provide a new type of vehicle for the issuance of such multiple class securities, and to
provide rules that are as comprehensive as possible for the taxation of all transactions
relating to the use of such vehicles.” Id. at 791. The Conference Report on the Tax
Reform Act of 1986 states: “The conferees intend that where the requirements for
REMIC status are met, that the exclusive set of rules for the treatment of all transactions
relating to the REMIC and to holders of interests therein are to be those set forth in the
provisions of the conference agreement.” H.R. Rep. No. 99-841, 99th Cong., 2d Sess.,
at II-230. Application of these rules is thus elective and the tax consequences of a
REMIC transaction follow from such election.

Section 860D(a) and regulations thereunder set forth a list of requirements that must be
met for an entity to qualify for REMIC treatment. As noted above, the Service asked
whether Taxpayer failed to form a REMIC for tax purposes and whether the transaction
should therefore be recast as a secured lending transaction. Here, Taxpayer and
Subsidiary have satisfied the requirements of § 860D, and all statutory and regulatory
REMIC requirements have been met. The Trust made an election to be treated as a
REMIC, all of the interests in which consist of one class of REMIC regular interests
described as Notes and one residual interest described as the Certificate held by
Subsidiary. Title to the RMB Securities was transferred to the Trust and Indenture
Trustee.

In addition, the REMIC rules specifically envision that a REMIC sponsor has a choice of
either retaining its interests in the REMIC or transferring them. This electivity is evident
in the rules governing the timing of a sponsor’s recognition of gain or loss with respect
to those interests. Under § 860F(b)(1)(A), a sponsor does not recognize gain or loss
upon transfer of any property to a REMIC in exchange for regular or residual interests in
the REMIC. A sponsor receives a basis in the regular and the residual interests
received equal to the aggregate basis of the property transferred to the REMIC and
such basis is allocated among those interests in proportion to their respective fair
market values. § 860F(b)(1)(B). If and when a sponsor sells any such REMIC interest
to a third party, the sponsor may then recognize gain or loss equal to the difference
between its adjusted tax basis in the interest sold and the amount received. § 1.860F-
2(b)(2).

A sponsor may also retain either a REMIC regular or residual interest. If the issue price
of a retained interest is more or less than the sponsor’s basis in that interest, then the
sponsor has unrecognized gain or loss in the interest, and the sponsor recognizes gain
or loss with respect to the retained regular or residual interest in accordance with the
applicable rules. See § 860F(b)(1)(C) and (D); § 1.860F-2(b)(4)(i) through (iv). Here,
the sponsor sold the REMIC regular interest and retained the residual interest, a result
permitted by the statute and regulations.

TAM-108896-14 10

Because Subsidiary met the requirements under the statute and regulations for REMIC
characterization, Subsidiary is entitled to a capital loss upon the sale of its regular
interests, and is also permitted to recognize loss on its residual interest ratably over the
anticipated life of the Trust under § 860F(b)(1)(D)(ii).

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.